February 21, 2018

Lessons From the Stock Sell-Off and Portfolio Strategy in an Expensive Market

Please read important disclosures HERE

Following an extended period of rising stock prices, stocks around the world sold off sharply in early February. This recent decline could be a helpful reality check for investors as long as it doesn’t lead to a major downturn in stocks. As stocks have climbed steadily higher through 2017 and into January, “animal spirits” (a term used to describe the instincts and emotions that guide human behavior) had begun to stir. Charles Schwab and other major discount brokers experienced a surge in individual investor activity, with new account openings in December and January rising to very high levels, per the Wall Street Journal.1 From mid-December through mid-January, flows into mutual funds and exchange-traded funds that invest in global stocks were at their highest levels since 2002, according to Bank of America Merrill Lynch.2 Over the same period, investor sentiment, reflecting expectations that the stock market will rise over the next six months, reached unusually high levels per the AAII Sentiment Survey.

This recent decline in the stock market contains a valuable lesson for investors. Often, when stocks are rising, it is tempting to conclude that the stock market is “safe” in the near term, an assumption that can lead investors to take more risk than is prudent. The recent market decline illustrates that stocks are never safe, particularly after periods of sustained gains. Sell-offs can seemingly come out of nowhere and be triggered by relatively minor developments such as the release of an economic report or news of financial troubles at a single company. Investors do not earn high returns by owning “safe” securities.

Reason to Be Careful

The sustained gain in U.S. stocks over the past couple of years has led to increasingly stretched valuation levels. The U.S. stock market, as measured by the S&P 500 Index, reached a cyclically adjusted price-to-earnings ratio (CAPE) of 33 in January.3 This reading was the index’s second most expensive level in history, exceeded only during the tech stock bubble of the late 1990s. Even after early February’s market decline, the CAPE remained quite elevated.

While high valuation levels might seem to be a good signal to sell stocks, the CAPE, in fact, has little short-term predictive value. However, the high CAPE does suggest greater downside risk if the currently supportive environment for stocks erodes.

Portfolio Strategy

Considering how best to navigate the current market environment, we are emphasizing two themes:

Remain disciplined. In rising stock markets, such as the one we’ve experienced over the past few years, disciplined risk management requires periodically selling stocks to keep portfolios’ stock allocations from drifting too far from their established targets. However, behavioral biases can make it more difficult to stick to the discipline of rebalancing one’s portfolio. For one, our brains are hardwired to expect recent market gains to continue into the future — referred to as “recency bias” in behavioral finance. In addition, studies indicate that investors tend to take greater risk when investing profits — referred to as “the house money effect.” These behavioral tendencies can lead investors to make decisions that ultimately prove costly.

In addition to behavioral obstacles, investors are frequently faced with having to pay taxes on gains when they sell stocks. A discussion of tax considerations when it comes to individual portfolios is tricky since every investor’s situation is unique and there’s no one-size-fits-all approach. Nevertheless, there are some primary considerations that generally apply. For instance, in some circumstances, investors may be able to avoid some capital gains taxes forever by gifting appreciated securities to charities or stepping up the cost basis at the owner’s death. However, even in these circumstances, many investors will be required to pay some capital gains taxes over time as they sell their stocks to fund spending needs. Quite often, it is better to pay some of these taxes in the near-term to rebalance the portfolio rather than risk losing much more than the amount of the taxes in a major market decline.

In general, unless there is a fundamental change in a person’s ability to assume more risk, the prudent strategy is to maintain one’s existing target stock allocation and stick to the discipline of periodically rebalancing.

Prefer less expensive stocks. Within the broad universe of stocks, less expensive stocks generally have two factors in their favor. First, they often have the potential for higher long-term returns than more expensive stocks. Second, less expensive stocks may provide better downside protection during broad market sell-offs. In the current market environment, we are emphasizing two categories of stocks that are inexpensive relative to the broad U.S. stock market based upon standard valuation metrics.

Value Stocks: Value stocks are stocks whose price is low relative to core metrics such as earnings, net assets (book value), dividends, or sales. On the other end of the spectrum, growth stocks represent companies whose stock price is high relative to these core metrics. Over the past 90 years, value stocks have provided investors with substantially higher returns than growth stocks.4 We believe this “value stock premium” is likely to persist in the future.

Recently, value stocks have become increasingly inexpensive relative to growth stocks. We believe this is a good time to increase the weighting of value stocks within diversified portfolios, with the goal of capturing more of the expected long-term value premium.

Foreign Stocks: Foreign stocks (in both developed countries and emerging markets) are currently inexpensive relative to the broad U.S. stock market. Over the past 10 years, U.S. stocks have generated much higher returns than foreign stocks,5 causing the spread between the CAPE of U.S. stocks and foreign stocks to become quite wide. Given this valuation gap, we believe foreign stocks are likely to provide higher returns than U.S. stocks over the next five to ten years. Over the past several years, we have been gradually adding to our clients’ foreign stock allocations and we are recommending a further increase to foreign stock allocations at this time.

Takeaways

The recent increase in market volatility and the high valuation of the U.S. stock market are reminders to investors to remain focused on their long-term investment plans. However, even at these higher valuation levels, we believe disciplined investors are likely to be rewarded with decent long-term returns,6 although perhaps not as high as the historical averages. Moreover, by emphasizing less expensive stocks, investors have the potential to earn better returns on their stock allocations than those provided by the broad U.S. stock market.

Footnotes:

1 “Lured by Market Records and Hot Bets, Individual Investors Finally Dive In,” Lisa Beilfuss, January 26, 2018
2 “Stock Market ‘Melt-Up’ Heralded by Record Investor Buying,” Ben Eisen, January 19, 2018
3 CAPE is an acronym for cyclically adjusted price-to-earnings ratio. It is calculated by dividing the current index level (price) by the average of the last 10 years of inflation-adjusted earnings. Source for CAPE data: Robert Shiller, Sterling Professor of Economics at Yale University, home page (http://www.econ.yale.edu/~shiller/).
4 From 1927-2017, U.S. value stocks and U.S. growth stocks had annualized returns of 12.75% and 9.22%, respectively. Source: Ken French, Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College website (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and Morningstar. All returns include dividends.
5 For the 10 years ending January 31, 2018, the S&P 500 (index of U.S. stocks) and the MSCI ACWI ex USA (index of foreign stocks) generated annualized returns of 9.78% and 3.44%, respectively. Source: Morningstar. All returns include dividends.
6 For a real-life example, consider the first time the CAPE reached 33 in February 1998. Over the nearly 20 years since, the S&P 500 has returned 7.13% (annualized through 01/31/18) while inflation has averaged slightly more than 2%. Source: Morningstar for S&P 500 returns, Bureau of Labor Statistics for inflation. All returns include dividends.

Disclosures

Filed under: Investing

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